Great Leap Forward

Banks Don’t Lend Reserves! Who Knew? MMT, That’s Who!

OK so it took almost four decades but finally the mainstream is waking up to the fact that banks do not “lend out” reserves (except to one another in the fed funds market). The whole “deposit multiplier” story that was taught in every American money and banking textbook is wrong. Always has been wrong.

(Just an aside: the mistake was largely an American deal. British students got to use Charles Goodhart’s text, which always got it right. But generations of Americans as well as foreigners who studied in America were misled by our textbooks.)

If our policymakers who art in Washington understood this, we would not have got QE. Or all the hyperinflation hyperventilating by those who fear that the trillions of dollars of excess reserves will get “lent out” and cause prices to go to the stratosphere.

Banks do not “use” reserves as the raw material for loan-making. Rather, they lend out their own deposits, which are created by keystrokes. Post Keynesians have been saying this since a seminal piece by Basil Moore was published in 1979 (and it is easy to find early precursors all the way back to the dawn of time–as I demonstrated in my 1990 book, Money and Credit in Capitalist Economies).

S&P’s top economist, Paul Sheard,┬áhas written an excellent piece, Repeat After Me: Banks Cannot And Do Not “Lend Out” Reserves published here: The whole thing is worth reading. Here’s a snippet, along with the citations he offered in support:

The Money Multiplier View Of Credit Creation. What is the defunct idea here that has such a grip on the world? Almost anyone who has taken an introductory course in economics or who has consulted a textbook on the issue will have studied the “money/credit multiplier” or “fractional-reserve banking” theory of credit creation. The story line is essentially as follows. Under a fractional-reserve banking system (the system in operation virtually everywhere in modern developed economies), banks have to hold a fraction of their deposits (a liability for them) as deposits at the central bank (called reserves) (an asset for them), but they can “lend out” the remainder. Given these reserve requirements (set by the central bank) and the public’s preferences for holding cash, there is a fixed “money multiplier” (the ratio of broad money to central bank reserves), such that a given amount of reserves multiplies into a much bigger amount of bank lending. The central bank supplies reserves to the banking system via open market operations or discount window lending, so when it increases reserves, given the fixed money multiplier, bank lending and deposits (or the broader money supply) should increase as well (*)…..

But the money multiplier has not collapsed because it was never there in a meaningful sense to begin with. Rather a ratio of two loosely connected numbers has fallen dramatically because the denominator was dramatically increased.

So how does QE work, and why can’t banks “lend out” reserves, and why is it that, if the central bank so deems it, banks (in aggregate) have to “park” their excess reserves at the central bank–so no one should be surprised if that is exactly what is happening?

There are two pieces to the puzzle: one, what determines the amount of reserves on a central bank’s balance sheet or “in the banking system,” as it is equivalently described; two, how credit creation happens–that is, how banks lend. Let’s take them in turn. A key distinction to bear in mind (hinted at in the last previous paragraph) is between individual banks and banks in aggregate. Neither individual banks nor banks as a whole can “lend out” reserves, but individual banks can and do offload their reserves (particularly excess reserves) by lending them to other banks or by buying assets; but the banks in aggregate cannot do this–in such cases, the reserves that leave one bank’s balance sheet just pop up on another, remaining on the central bank’s balance sheet all the while.

Most importantly, banks cannot cause the amount of reserves at the central bank to fall by “lending them out” to customers. That possibility is not allowed for in the identity because bank lending does not enter into it. Assuming that the public does not change its demand for cash and the government does not make any net payments to the private sector (two things that are both beyond the direct control of the banks and the central bank), bank reserves have to remain “parked” at the central bank. To express wonder that banks don’t lend out their reserves or that they park them at the central bank is to fundamentally misunderstand the balance-sheet mechanics of credit creation and how QE works.

*Citations: Although the “money multiplier” view of central banking and credit creation is the dominant one, largely I would posit because its pedagogical attractiveness makes it a “dominant meme,” other schools of thought have long existed in economics and have come to the fore more recently in the guise of “modern monetary theory (MMT).” See, for instance, Wynne Godley and Marc Lavoie, 2007: Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth (Palgrave Macmillan); L. Randall Wray, 1998: Understanding Modern Money: The Key to Full Employment and Price Stability (Edgar Elgar); L. Randall Wray, 2012: Modern Monetary Theory: A Primer on Macroeconomics for Sovereign Monetary Systems (Palgrave Macmillan).
Nicely put, and cited. Would have been even nicer if he cited my 1990 book!

36 Responses to “Banks Don’t Lend Reserves! Who Knew? MMT, That’s Who!”

William WilsonAugust 15th, 2013 at 7:55 pm

"If our policymakers who art in Washington understood this, we would not have got QE. Or all the hyperinflation hyperventilating by those who fear that the trillions of dollars of excess reserves will get “lent out” and cause prices to go to the stratosphere."

So what was FED Chief B Bernake's theory for intorducing QE?

Ben JohannsonAugust 15th, 2013 at 7:57 pm

Dr. Wray, I want to thank you. I've learned a tremendous amount over the last three years since I first tripped across a mention of the State Theory of Money in the comments section of a blog and that's due to the willingness of you and the other MMT founders to engage with the public.

I'm pleased to see you all finally receiving credit for gathering together so many varied insights into a coherent framework representing a real step forward in economics. Please keep writing.

Rob RawlingsAugust 15th, 2013 at 8:31 pm

I have a question on 'all the hyperinflation hyperventilating by those who fear that the trillions of dollars of excess reserves will get “lent out” and cause prices to go to the stratosphere'.

Isn't the reason that these excess reserves currently don't cause inflation is that no-one wants to borrow them (at least anyone who the banks are prepared to lend to).? If lending increased (and the borrowed money was spent) then would this not eventually be inflationary if the CB did not take steps to drain reserves by selling assets (or sterilize them by increasing IOR)?.

If none of the new loans ever resulted in increased cash-holdings then indeed the total amount of reserve would stay the same but this would not stop the increased spending from being inflationary.

Rob RawlingsAugust 15th, 2013 at 8:51 pm

Actually I just answered my own question by reading "Repeat After Me: Banks Cannot And Do Not “Lend Out" (which is excellent).

The answer is of course that as banks increase lending then reserves would be created if they do not already exists. The current level of excess reserves is therefore irrelevant to future lending activity (and its effect on inflation).

Lee AdlerAugust 15th, 2013 at 9:07 pm

This is just basic Accounting 101. I have been harping on this for ages. Very frustrating given the misinformation from mainstream economists and pundits in the mainstream media. About Those Reserves On The Fed's Balance Sheet, Again, Sigh…

lxdr1f7August 16th, 2013 at 5:03 am

We operate a two tier monetary system. Reserves are mainly for banks interacting with the CB and commercial bank deposits are what everyone else uses. We need to create a balanced system.

Nick EdmondsAugust 16th, 2013 at 9:48 am

I was interested in your comment that belief in the money multiplier is a American phenomenon. I studied economics in the UK in the 80s but, since then, haven't paid much attention to the subject until recently. Having come back to it, I have been thoroughly perplexed as to how the money multiplier seems to I have gained so much credence. Although I learned about the relationship between broad and narrow money, I don't recall it ever having been suggested that the causal relationship ran from reserves to loans (and this was at the height of monetarism).

L. Randall Wray L. Randall WrayAugust 16th, 2013 at 12:42 pm

Rob: read the S&P piece. Banks lend reserves ONLY to each other. They cannot ‘GET OUT’ of the Fed. No bank can lend them to you because you don’t have an acct at the Fed

L. Randall Wray L. Randall WrayAugust 16th, 2013 at 12:45 pm

Nick: yep, it is strange indeed. Unfortunately, as you know, US economics came to dominate the world. UK economists (mostly) knew better.

lxdr1f7August 16th, 2013 at 1:55 pm

Anytime you want you can barter. But I would like to use an efficient monetary system that doesnt favor banks or depend on them to create most of the money supply.

PZAugust 16th, 2013 at 5:58 pm

With central banks now paying interest on reserves, isn't the reason for issuing govt. bonds gone?

Wouldn't it be sensible reform to get rid of govt. bonds altogether and just pay interest on reserves?

Lake Erie LiberalAugust 16th, 2013 at 8:18 pm

Would the following be a correct description in practice how a loan would create a deposit and the deposits might move throughout the banking system?

I want to start a Widget making business.

I go into a Key bank branch in Cleveland, Ohio and they have capital and find me to be a credit worthy borrower. I receive a $100,000 loan. This creates a deposit and Key Bank credits an account for me at a local Key Bank branch in that amount. Is it correct to say that this also increases Key Bank's Reserve Account at the Cleveland FED by that amount as well?

Then, I go to buy some parts from a supplier in New York for $20,000 that has a bank account at Chase Bank. Chase Bank sends an instruction to Key bank to debit my account $20,000. Then, Key's account at the Cleveland FED is debited by $20,000 while Chase Bank's Reserve account at the NY FED is credited $20,000 and finally the supplier's checking account at the Chase Branch is credited $20,000?

PZAugust 16th, 2013 at 8:24 pm

Here is Victoria Chick who taught economics for 40 years in the University College London:

Why don't economists understand money?

"It is a very strange act of fate, that I have been in this business long enough, for the kind of understanding you have been exposed today (about where money comes from) to constitute a return to what I was tought as an undergraduate. "

"When I was a student in the late 50's and early 60's, it was widely understood, absolutely taken as granted, that the causality went from loans to deposits. Loans create deposits.

Now students are all tought that banks lend on deposits, that the deposits create the ability to lend and banks respond to that. This is regression! "

It would be interesting to hear whole story how loanable funds doctrine was invented and how did it propagate. If I knew any good sources I would update loanable funds page on wikipedia. There is always room for alternative views, but they have to be properly sourced.

Lake Erie LiberalAugust 16th, 2013 at 8:36 pm

"While banks cannot control the overall level of excess reserves, there are a several ways they can reduce the level of excess reserves on their own individual balance sheets. They can lend excess reserves to other banks in the federal funds market, they can lend them to consumers or businesses, or they can purchase securities. Each of these outlets has been constrained for various reasons since the recession."

I think this is the relevant quotation? Are the researchers at the Cleveland FED getting it wrong too?

Frank in SFAugust 16th, 2013 at 9:03 pm

In light of this rather significant discussion, please explain Bernanke's rationale for QE, and why is Yellen so much in favor of continuing. And, as a related questions, if QE is so effective and non-inflationary, why discontinue QE?

L. Randall Wray L. Randall WrayAugust 17th, 2013 at 12:59 pm

Liberal: yes that is wrong. a bank cannot lend reserves to consumers or firms; those don’t have accts at Fed

L. Randall Wray L. Randall WrayAugust 17th, 2013 at 1:01 pm

Not quite. A bank creates demand deposits when it lends. However that does not directly create reserve deposits at the central bank. when the bank needs reserves for clearing (your final step) it borrows them.

L. Randall Wray L. Randall WrayAugust 17th, 2013 at 1:02 pm

pz: yep. interest paying reserves function in the same way as interest paying bonds. the difference is maturity. mkts like long maturity bonds. might be in public interest to issue them.

L. Randall Wray L. Randall WrayAugust 17th, 2013 at 1:03 pm

Lxd: and you probably want beer flowing from fountains, too! and unicorns in every yard. (-)

Lake Erie LiberalAugust 17th, 2013 at 6:17 pm

I see. But, if the Bank had plenty of reserves on hand for clearing there would be no need to borrow any, correct?

So, in my example, when the Cleveland FED and the NY FED settle the transaction between Key Bank and Chase Bank; Key Bank's Reserve Account is debited and Chase's is credited ultimately but the new demand deposit didn't create any new reserves.

L. Randall Wray L. Randall WrayAugust 18th, 2013 at 1:29 am

In normal, non QE times, banks didn’t hold XR. As necessary they borrowed them. Res Rqmts are calculated complexly, up to 6 wks after the fact. In any case it is net clearing that matters, and that is expost to loan and deposit creation.

PZAugust 18th, 2013 at 5:22 pm

Maybe now is right time to push for changes now that understanding is changing. Getting rid of 'government is borrowing' rhetoric would be priceless, absolutely priceless.

And this language we use is such that false understanding might very well stage a comeback sometime in the future, maybe 30, 50, 70 years from now. Some sort of a change would be required to solve this problem once and for all.

Tejas552August 19th, 2013 at 6:19 am

Paul Sheard is of course correct, in the aggregate, banks cannot reduce or increase the level of excess reserves (unless they store cash in vaults). The level of aggregate reserves is determined by the central bank alone – at least in the current situation. The creation of these reserves affects relative prices. It pushes up asset prices in particular (e.g the current bond and equity bubbles/plus house price bubbles in several countries). Thus, QE affects the degree of risk aversion in the economy. Interestingly, it works not just in level terms and terms of changes it also works in the second derivative. Thus, any hint that asset purchases (i.e. QE) is even slowed down will and has caused massive repricings in the asset markets.

Reuven brennerAugust 20th, 2013 at 12:09 pm

Bernanke himself gave the answer- he is replicating what the fed did during 1940-51, under presudential/treasury orders, keeping interest rates low. Was simply fiscal policy to carry and pay for the war debts. Redistributing from savers – without formally imposing a tax. See my piece in the wall street journal about this, titled bernanke s wwii monetary regime.

Reuven brenner

L. Randall Wray L. Randall WrayAugust 20th, 2013 at 4:21 pm

Reuven: I mostly agree: ZIRP helps to keep other rates down which also reduces govt deficits (which they think is a good thing, but actually adds another headwind against the recovery). But the point is you do not need QE to keep overnight rates at zero. You just announce Zirp then make sure you supply reserves on demand at that target.

L. Randall Wray L. Randall WrayAugust 20th, 2013 at 4:26 pm

tejas: still riding the expectation fairy? Yes Zirp might have helped fuel some asset mkts. QE on top of Zirp adds nothing significant, except more headwinds against recovery.

Lake Erie LiberalAugust 23rd, 2013 at 2:39 pm

Professor Wray,

In the event of austere fiscal policy like we have now can QE encourage private sector credit expansion above and beyond what is encouraged by ZIRP???

stanislaus2September 25th, 2014 at 9:12 am

Sheard's article added much to my understanding. However, on p. 8 of Sheard's article, he says: "In a closed economy…fundamentally, deposits come from only two places: new bank lending and government deficits. Banks create deposits when they create loans, as explained above. Governments also create deposits when they run budget deficits because they are putting more money into the public's bank accounts than they are taking out. This net flow creates new deposits in the banking system, which has its counterpart on the bank's balance sheet as an increase in reserve."

But doesn't the Treasury have to borrow from the banks (law passed in 1917) to deficit spend? Sheard assumes that new money (Federal Reserve Notes) in circulation is created by the Fed when the banks lend new loans and the lent money goes into circulation. Can someone respond to this? In a fiat system where the Treasury creates new money ex nihilo I can see how Treasury would create the money as it spent it into the public's bank accounts. But the idea that the private banks create the money and lend it to the Treasury suggests that the banks essentially create the money for the government's deposits. Does Sheard's account encompass both of these ways in which the Treasury could get its money to spend on deficits? Treasury creates ex nihilo versus banks create new money ex nihilo (with help from Fed).

stanislaus2September 27th, 2014 at 5:05 am

Sheard's explanation is proper for a plain vanilla flavored fiat money system where the government can create money to cover deficits. But what about our banking system where the Treasury has to borrow from the banks to cover deficits (due to a law passed in 1917)? When Treasury could just issue US Treasury Notes (greenbacks) to cover deficits, it could create new deposits in the private sector by spending the money it creates out of nothing. (I've read Sheard's paper quite closely because I translated most of it into another language). There is no direct connect between when our Fed buys the securities that the Treasury has sold to banks for money to cover deficits. Most of the time the Treasury just rolls over the securities in cooperation with the banks, who use the securities as a cash cow for earning interest for nothing. Only when the banks need to sell their Treasury securities to get quick cash, and the Treasury doesn't have it (it had to borrow to cover the deficits), might the Fed end up buying those deficit-covering securities with money the Fed creates out of thin air. So maybe in the very long run the government (via the Fed) creates the money to reimburse the banks and redeem the loans on the securities. The Fed can hang on to the securities it bought for some time until there is a serious inflation. When that occurs it can swap the mature securities it has from the banks for new securities from Treasury (that's legal). At this point the Treasury may extinguish the old mature securities. But I don't know. They may have a vault somewhere in which they store them. But the mature securities are now just like money and can be used to buy things with, because they can be exchanged for face value with Federal Reserve Notes. The Fed will make this swap for new securities, because it will sell the new securities to banks to take their excess reserves from them. Banks get immature securities and Fed takes their excess reserves and records them somewhere and who knows where they store the paper securities. Later as the securities mature, Fed may return the banks their money from the time deposits plus interest it creates out of thin air. It gets back the now mature securities and can use them later to swap with Treasury for new securities as before if needed again to further fight inflation. Inflation could occur by the banks creating too many new loans. So, inflation need not be the government's doing in "printing" too much money for government spending. Inflation could be the responsibility of the private sector banks and financial institutions creating too many loans out of thin air.